An irrevocable life insurance trust (ILIT) allows the death benefits of the life insurance it purchases to be received income- and estate-tax free. However, necessary gifts each year by the trust creator to pay premiums causes a gift-tax problem. The larger the premium, the larger the problem. The tax strategy marriage eliminates this problem and creates tax-free and wealth-building opportunities.
An intentionally defective trust (IDT), which is also irrevocable, is defective only for income tax purposes. An IDT can be used to transfer income-producing assets from parents to their kids, tax-free.
Before we discuss the wedding of the ILIT and IDT, there is one more concept you should know: “arbitrage.” This is the purchase and sale of the same or equivalent security in different markets in order to profit from the price discrepancies.
Here’s what makes this marriage work: If you own an asset that currently earns a rate of return that exceeds today’s low interest rates, you can use the arbitrage profit to pay insurance premiums (creating tax-free wealth) while avoiding the loss of any dollars to the IRS for taxes.
Wait, there’s more. Tax law allows you to take various discounts that reduce the real-market value of the asset in the 30- to 40-percent range for tax purposes. If you increase the arbitrage profit, you make a tax-saving slam dunk.
Now, let’s run through an example to initiate and complete an arbitrage ILIT.
• Step 1. Create the arbitrage ILIT. Your lawyer must create the trust defective for income purposes, combining the ILIT and IDT in one document.
Let’s use Joe as an example. He is personally responsible for paying the income tax due on all trust earnings because the trust is ignored for income tax purposes.
Before I go on, let’s look at some basic facts: Joe is married to Mary. Their second-to-die insurance policy is $11,832 per $1 million of death benefit. Joe owns Success Co., an S corporation worth $6 million and run by his son Sam. Joe and Mary want Sam to own Success Co., but they also want to treat their two non-business kids equally. Aside from Success Co., they have $5 million of other assets, half of which are liquid.
• Step 2. Select the asset to sell to the ILIT. Joe should sell one of three types of assets to the ILIT: stock of a closely held business; an interest in a family limited partnership (FLIP), which owns real estate and/or securities; or an interest in an LLC. The transaction is arranged so he keeps absolute control of the asset for as long as he lives, even though the asset is out of his estate.
Joe decides to sell all of the non-voting stock (10,000 shares) he owns in Success Co. to the ILIT, keeping all (100 shares) of the voting stock.
• Step 3. Have the asset sold to the ILIT professionally valued. Get a professional valuation of the asset with the expert determining the discount of the asset. This is almost always about 40 percent for the non-voting stock of a family business, so $1 million of stock is worth only $600,000 for tax purposes. Also, this is almost always about 35 percent for a limited partnership interest in a FLIP, so $1 million of such an interest is worth only $650,000 for tax purposes. These discounts supercharge the arbitrage profit.
Success Co.’s 10,000 shares of non-voting stock have a fair-market value of $6 million. However, after the appraisal expert applies a 40-percent discount (amounting to $2.4 million) the stock is worth $3.6 million for tax purposes. Note that future earnings of Success Co. are estimated at $1.2 million per year.
• Step 4. Pay for the assets sold to the ILIT. The ILIT pays Joe for the 10,000 non-voting shares with a $3.6 million note with 4-percent interest.
• Step 5. Purchase life insurance. Remember, the ILIT’s income is estimated at $1.2 million per year. The ILIT purchases $6 million of second-to-die life insurance on Joe and Mary, which costs $70,992 per year ($11,832 X 6).
• Step 6. Operate the trust. The trust will use the dividends from Success Co. (say $1.2 million) each year to pay the insurance premiums ($70,992), the interest due on Joe’s note (about $144,000 the first year) and the balance to pay down Joe’s $3.6 million note. The arbitrage profit is huge: the difference between Success Co.’s profit and the interest.
• Step 7. Finish the task. Someday Joe’s note will be paid in full. Then, using the income stream from Success Co., the ILIT will continue to pay the policy premiums, and the three children will share the balance of the income. When both Joe and Mary have gone to the big business in the sky, the ILIT will receive the $6 million death benefit tax-free.
The 10,000 shares of non-voting stock will be distributed to Sam, and the $6 million insurance cash will be used to treat the three kids equally.
Some final thoughts: This ILIT/IDT strategy can be tailored to almost any situation in which you own income-producing assets. However, even though the arbitrage ILIT is a powerful tax-saving weapon, there are tax traps and nuances of this strategy. Be sure to work with a professional.